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Fixing a Broken Portfolio: Is it OK to Sell Low?

Dan writes in to ask,

“I have a portfolio with a large brokerage firm. It’s primarily invested in individual stocks, with a handful of mutual funds thrown in as well. The individual stocks have performed very poorly. The mutual funds have performed better, but (I’m now learning) they have very high expenses and they’ve underperformed the market by a wide margin.

I know that I want to move my money. I’ve been reading on your blog and in several books about using index funds to invest with low costs. But if I sell everything now, after a period of very poor performance, wouldn’t I be selling low? Isn’t that the opposite of prudent investing? Wouldn’t it make sense to wait a few months to see if the stocks come back?”

I get lots of emails like this. People realize that their portfolio is a mess and that it has performed very poorly. Sometimes they even know exactly what they’d like to switch their portfolio to, but they are still reluctant to make the switch because they don’t want to “sell low.” They don’t want to “lock in” their losses.

Look Forward, Not Backward

The problem with this line of thinking is that, tax considerations aside, it’s irrelevant how your portfolio has performed in the past. The only thing that matters is how to make it perform as well as possible in the future.

It can be helpful to look at the situation this way: If your entire portfolio was in cash right now, how would you invest it?

However you answer that question is (in most cases) how you should invest your portfolio.

If you have such a reason, why switch your portfolio at all? And if you don’t have such a reason, why wait to make the switch?

And remember, the mere fact that a stock has declined in the recent past (or that a mutual fund has had sub-par performance) is not a reason to think it’s going to have better-than-average performance in the future.

Possible Exceptions

There’s a potential exception for investors who are currently invested in funds that have contingent deferred sales charges. These charges are commissions on certain share classes of certain mutual funds that are charged if you sell the fund within the first several years. Because they decrease (and eventually disappear) over time, it sometimes makes sense to wait before selling the fund.

Alternatively, if the investments in question are in a taxable account, it can sometimes make sense to stick with your current holdings in order to avoid paying taxes on large capital gains, even if those holdings are not something you’d buy if you were just getting started today. However, if your current holdings have unrealized capital losses, “selling low” would provide some tax savings — giving you all the more reason to make the switch now.

New to Investing? See My Related Book:

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

With respect to his point about not wanting to “sell low”. If Dan is selling a mutual fund which is invested in the S&P500, sells and then buys a broad based index fund/ETF based on the S&P500, he isn’t really selling low. In fact he’s likely just “transferring low” – his old fund might be down, but so is the fund he’s buying.

Obviously this won’t work perfectly, especially with the individual stocks, but the same idea should apply to some degree.

If you’re just looking at market asset value, it’s easier to sell than if that asset is producing a sizeable income stream.

For instance, you buy a bond fund at $20/share yielding 5%. The bond fund market value then sinks to $15/share, but the distributions continue at their prior level (increasing yield to 6.25% if I’ve done my sums right). Your income hasn’t changed, but your net worth went down 20%… which is more important?

“Psychologically speaking, the tenancy to get to the break-even point is very powerful, but one must mentally realize that the capital that you have remaining doesn’t have to be deployed in the same vehicles that you lost your money with (e.g. averaging down) or just after the time the capital was lost (e.g. Thursday). Investing should be done when the conditions are ideal and right and that includes looking at the external marketplace and also inside your own head to make sure you are thinking clearly.”

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